Financial-market Outlook: Cognitive Dissonance
By podcasts@redstate.com (Redstate Network) on Economy
This pair of stories appeared near each other on Bloomberg's front page recently.
On the one hand, the outlook for the US dollar is seen as weakening further, along with expectations for lower interest rates. On the other hand, US stock markets are in near-record high territory as the US economic outlook brightens.
Let's see if we can square the circle.
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The "rates are falling further" perspective:
The dollar approached an all-time low against the euro on speculation the interest-rate advantage that U.S. securities hold over Europe debt will narrow.
The U.S. dollar fell against 13 of 16 most-actively traded currencies this week, and reached a 31-year low against Canada's dollar. A government report on Oct. 17 is forecast to show U.S. housing starts declined to the lowest in 12 years, adding to expectations the Federal Reserve may cut borrowing costs to prevent the economy from going into a recession.
``The overall view is that the U.S. economic fundaments [sic] will weaken further,'' said Paresh Upadhyaya, who helps manage $29 billion in currency assets at Putnam Investments in Boston. ``That will have the Fed keep an easing bias. While the rest of the world is tightening, interest-rate differentials are working against the dollar.''
The near-term dollar weakness is to be expected in the wake of the Federal Reserve's recent large cut in benchmark interest rates. Lower-yielding securities will always tend to attract less foreign capital, reducing the demand for dollars to buy the securities with.
The questions about the dollar become more interesting in the next few months as the near-term effects of the Fed's policy change dissipate. The dollar's foreign-exchange value also reflects global investors' views on the attractiveness of other US assets, relative to assets available elsewhere.
If you're among those who are expecting another interest rate cut from the Fed sometime before the end of the year (and you'd be in very distinguished company), then you're also a dollar bear, as is the Putnam portfolio manager I just quoted.
But what about the more recent economic statistics? Job growth in August and September surprised on the upside, according to the Labor Department's most recent report. And the stock markets are telling us that the earnings outlook for US public companies is bright. From the second article I linked above:
U.S. stocks rose for a fifth straight week, the longest stretch of gains since May, after minutes from the Federal Reserve and better-than-expected retail sales bolstered expectations that the economy will keep expanding.
...snip...
Minutes from the Fed's Sept. 18 policy meeting showed central bankers avoided language that might have suggested the economy would fall into a recession. The Commerce Department said retail sales increased 0.6 percent last month, from the 0.2 percent gain predicted by analysts in a Bloomberg survey.
``The consumer is a staying force, earnings growth is going to prove better than we think and that's the best outcome for the stock market,'' said James Paulsen, who helps oversee $175 billion as chief investment strategist at Wells Capital Management in Minneapolis. ``There are still good possibilities here.''
The question frequently comes up: "What the heck does the Federal Reserve know about the economy anyway?" To me, they're in the best possible position to sense the economic condition of the various regions. There are twelve Federal Reserve Banks, and they work very closely with the commercial banks in their respective zones of the country, while the New York Fed is tightly plugged into Wall Street. On the whole, the Fed Banks have a terrific view of credit conditions around the country, and these are strongly predictive of future business activity. Fed staff are certainly not immune to biased judgments, but their raw data is the best there is.
Conditions in the housing markets and the mortgage industry are still abysmal, with several major homebuilders and lenders in deep financial trouble. The short-term corporate credit ("commercial paper") market is still largely frozen.
But the middle and long ends of the US Treasury yield curve are now riding considerably higher than they were at the depths of the August financial crisis. Additionally, the Japanese yen is now weaker on most days than it was during August (which means increased carry-trade activity). To me, these two items are a barometer for the amount of risk that global investors are taking. And the barometer is rising.
US stock markets are cruising higher, having erased the 8% July-August tumble (10% on an intraday basis). This in itself indicates a brighter outlook for corporate earnings.
Considerable sector rotation has taken place over the last three weeks, since the Fed cut the fed-funds rate, and this is an important part of the market story. Investment managers have been shifting a lot of money out of certain sectors (like financials and homebuilders), and into others (like commodities and consumer-nondurables). This should be telling you something important about the mix of corporate earnings in the coming quarters. Commodities, Chinese equities and technology stocks have been on a wild rocket ride.
So who's right? The dollar bears or the equity bulls?
You can't realistically discount a US recession (and consequently expect more easing from the Fed), and also expect US corporate earnings to keep rising on the back of stronger job growth and consumer spending.
I believe the correct long-term perspective is for continued strong growth in the global economy (including moderate growth in Europe), together with slow-to-moderate growth in the United States. The subprime crisis, which had its roots in the US housing-market bubble, is a bump in the road and does not change the larger trend.
On this view, the value of the US dollar should continue to decline relative to other currencies as the rest of the world outperforms the US. However, several factors will moderate the dollar's weakness.
First, the US economy may not slow all the way into recession. The United States may be in the early stages of a secular shift away from its role as the world's growth engine. The stock market sectors which are showing the greatest strength now are also the ones that have high growth potential in overseas markets. I think the future for the US economy is as an export engine to faster-growing economies elsewhere in the world.
Second, inflation is now a major problem almost everywhere in the world, except in the United States (and Japan, of course). We continue to be the primary beneficiary of globalization.
And third, the surprising job growth and domestic economic performance may continue, which should put a floor under US asset values.
How all of this plays out politically is a completely different question. I still have yellowed newspaper clippings from the first Clinton Presidential campaign ("the worst lying about the economy in 50 years"). Brace yourselves for more, as the Democrats compete with the Norwegian Nobel committee to convince everyone that widespread poverty and death from poor health-insurance, undertaxed rich people and global warming are imminent. redstate.com |
